When asked to compare the value of two bonds, many portfolio managers refer to spread relations obtaining in the past —a practice that can be a dangerous trap unless it takes into account changes in the general level of interest rates. For example, spread differences are influenced by vulnerability to call, which becomes a problem for high coupon bonds as the general level of interest rates falls. As soon as such a bond begins to sell on the basis of its yield to call, rather than its yield to maturity, the historical spread between its yield to maturity and that on a lower coupon bond will cease to govern.
The author suggests that the investor begin his yield spread analysis by calculating the yield to maturity that a current coupon bond of the same credit would enjoy. Using the concept of basis points per eighth of coupon, the investor can then work upward or downward to establish the approximate yield for the actual coupon of interest.
Because of call considerations, the yield impact of one-eighth difference in coupon is less for a discount issue than for a premium issue. Then too, basis points per eighth of coupon will vary over time depending on interest rate expectations; the market places an increased value on discounts when interest rates are falling.
Fluctuations in spreads can produce enormous change in bond prices. Understanding the effect of coupon yield spreads at various stages of the interest rate cycle can sharpen the portfolio manager’s ability to make advantageous yield swaps.